Charlie Barnhart & Associates LLC

Business is an inherently risky proposition and today’s maximum velocity business models based on complex, highly leveraged solutions make the situation even more perilous. Never the less, the trend is clear – electronic product companies (or OEMs) continue to outsource more functions, more often, to more geographically remote locations than ever before. Why do they do this?

Some might say to they do so to coldheartedly bolster corporate profits by chasing low-cost labor around the world, and given the sometimes negative human impact resulting from liaises faire globalization the argument is compelling. But the main (or operative) answer is that companies must continuously gain competitive advantage if they are to survive in today’s marketplace, where competitors exploit even the slightest level of indecisiveness.

So what is a conscientious manager to do?

1. A good first step would be to acknowledge that high velocity means high risk
2. Secondly, accept accountability for any issues resulting from this risk.

While this may seem painfully pointed, consider who loses the most when your customers’ orders go unfulfilled, or when your company fails to meet its financial commitments? It is your business, you are responsible.

Acknowledgment that high velocity means high risk should also be factored into the planning and decision making processes. After all, risk is not something to be automatically avoided. History is rife with examples of companies who took huge risks and became legendary because they did – ever hear of Boeing and the 747 or Federal Express and overnight delivery? The issue is not simply how to eliminate risk, but how to set and measure a return-on-investment on the risks you take. This approach transforms risk from an unknown into something manageable.

A case in point would be choosing an Original Design Manufacturer (or ODM) for a new product. This approach provides OEMs with increased velocity in product introduction as well as a lower purchase price than is typically achievable with an Electronic Manufacturing Services company (or EMS) building an in-house OEM design, thus producing a threefold advantage – lower design cost, lower manufacturing cost, and reduced time-to-market. But what about the risks?

Referencing a Technology Forecasters Quarterly Forum report dated June 2004 and titled Original Design Manufacturers: Viable Alternative/Distinct Business Processes, we find a list of potential pitfalls with the ODM model:

• Loss of internal expertise and competencies

• Unrecoverable loss of IP and/or market opportunity

• Diminished institutional understanding of IP value

• Dilution of Brand and/or differentiation

• Shift of organizational focus from bottom-line to top-line

• Unintentional creation of enterprise momentum

• Simultaneously increase of supply and geographic exposure

• Increased cost/complexity of maintaining adequate surveillance

• The theoretical “kinetic energy risk” to business (i.e., the v² factor)

Recognizing there are more items in the above list than we can address in this commentary, let’s focus on those risks that align most closely with our three advantages, of:

1. Lower design costs

2. Lower manufacturing costs

3. Reduced time-to-market

Starting with lower design cost the most applicable pitfall is unintentional creation of enterprise momentum, as performing product design outside the company can result in the unintentional elimination of a capability or resource core to a businesses’ success. For example, there is always some probability – all be it slight – that a key engineer may decide to ‘jump ship’ as a result of seeing his/her co-workers being laid-off or passed over for additional training as a result of designs being outsourced to ODMs. Should this occur what would cost to replace the resource? Does the probability of occurrence, multiplied times this predicted cost, produce a number smaller than the potential saving from outsourcing the design?

The next advantage sought–lower manufacturing cost—results (at face value) from ODMs benefiting from a broader level of participation in the sub-tier supplier selection process than EMS companies, which affords them greater influence in these relationships thus lowering material costs. And as material cost is the largest single element of cost-of-goods in virtually every electronic product, this can equate to a very significant cost savings for the OEM.

Yet, as ODMs and their supply base are located in close proximity, this model also simultaneously increases supply and geographic exposure. Because not only your ODM, but also all of your ODMs’ suppliers and suppliers’ suppliers are probably located in China, they may be subjected to the same infrastructural, monetary, and geopolitical risks. How long, and at what cost, would it take to replace this supply base? What percentage of your company’s revenue and profits would be derived from this product? Do the estimated savings outweigh the potential impact of a catastrophic failure of the supply solution?

Our final advantage is reduced time-to-market. If real estate is all about location, location, location, then the electronic industry is all about timing, timing, timing. Having the right product, at the right place, at the right time makes or breaks a business offering. Especially in a market sector as fickle as consumer products which is where ODM solutions are often applied.

Physics tells us kinetic energy, or the energy of motion, is calculated as one-half times the mass of an object, times its velocity squared.

Kinetic energy = ½ _X mass _X velocity²

In other words, the larger something is and the faster it moves the more kinetic energy it possesses. But there is an interesting consequence of the final element of the equation, velocity squared: whenever you multiply a number by itself, the result is geometric–not linear–expansion. Let’s take a closer look to see what this means.

If you square the number 2, the answer is 4. But if you square the number 3, the answer is 9–an increase of 225% for only a 50% increase in the original number. Throw a stone just a little faster and it impacts its target with considerably more force. Or reduce the time-to-market by increasing the velocity of the process and, if the analogy holds true, the risks grow dramatically. Even as a theory, it is a very scary thought.

If you attended a business school you probably heard of the “potential energy” effect, which is the force accumulated within an enterprise as it grows larger, which eventually (if left unmanaged) will bring the organization tumbling down. The analogy in nature, from which this effect is derived, is that whenever you lift an object it instills into it potential energy and this energy is fully expended only when the object falls back to its original height.

So a kinetic energy risk has a well documented parallel in business theory in addition to a strong basis in common sense, a combination that is hard to ignore. Maybe someday, someone will perform the necessary design-of-experiments to fully validate the theory. In the meantime, perhaps a little paranoia when increasing the velocity of business processes would be wise.

Remember it was once said, “Paranoia is only a disease when it is unjustified.” Given the velocity of change in the electronics industry, the economy, the US, and the world – a little paranoia seems more than justified.

Tags: OEM strategies, Risk Management by Charlie
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An often used analogy links air-traffic controllers’ use radar to direct the flow of airplanes with how problems or issues in business are prioritized and tracked. Ever hear the expression, “that’s on our radar” or “that must be below the horizon as it hasn’t shown up on the radar yet”? Meaning if something is known it is on the radar and conversely if something is unknown or unexpected it’s off the radar.

So what does radar have to do with common sense, human nature, and the fundamental tenets of business?
It all started in the mid-twentieth century[1] when almost simultaneously the United Kingdom, Germany, and the United States all discovered that dropping small metallic strips from an airplane generated a cloud of echoes that rendered radar information confusing and useless. In a word, this electronic-countermeasure was referred to as Widow by the British, Düppel by the Germans, and Chaff by the Americans.

Today, in in the Outsourcing Navigator Series, we use the term Chaff – and a little poetic license – as an acronym for:

C ommon sense

H uman hature

a nd the

F undemntal tenets of business

It is usually under one of these three headings that the misconceptions about outsourcing can be categorized.

Let’s review by way of example.

Common Sense

For this item let’s use the big fish, little pond - little fish, big pond comparison as it’s the most commonly referenced analogy when discussing the scale of outsourcing requirements and potential supply solutions. Just in case the reader isn’t familiar with this parallel a brief summary follows.

Common sense tells us, that to avoid risk and maximize the potential for success when outsourcing, we need to make sure the size of the requirements aligns with the capacity of the supplier. In other words, if we need $4 million worth of outsourcing manufacturing done per year we should consider a supplier who is scale appropriate for this level of work.

In the GPW we classify scale appropriate as being somewhere between 5 to 15% of a supplier’s total annual revenue. Therefore a scale appropriate supplier for our $4 million outsourcing project would have annual revenue between $27 and $80 million dollars – or rounded off, $25 to $100 million per year.

A hard and fast rule – NO. But certainly a strong starting point from which rational judgment can begin to be applied.

So with a little common sense, and a splash of guidance from the GPW, it’s fairly easy to make sure you don’t end-up being either a big fish in a little pond (where there may be inadequate amounts of food and you won’t be able to grow) or a little fish in a big pond (where you’ll have to compete with all the big fish and may end-up getting eaten yourself).

Yet in approximately 33% of cases labeled as problematic in the Global Outsourcing Tool (GO Tool) data base[2] root-cause analysis clearly indicates that inappropriate scale alignment was the key factor in outsourcing failure.

How did this happen? In most cases it was when common sense got clouded by the Chaff of misguided internal rationalizations (“If we’re a big fish in a smaller pond we’ll get more attention!”) or some form of wishful group-think (“We need multiple tier-one EMS suppliers as our new product is going to be the next big-thing!).

Human Nature

While human nature sounds complicated it’s actually the easiest of the three Chaff issues to explain and I usually do so by sharing the following real-world anecdote:

An EMS supplier calls their OEM customer to inform them that they’ve been unable to secure a certain part (or a commitment for delivery of a certain part) to meet the requested delivery requirements of the OEM and asks the OEM for help in finding and/or expediting the required material. To whit, the OEM makes a single phone call and immediately secures a commitment from the component supplier to ship the required part as requested.

All of which results in the author’s phone ringing and an upset OEM client “at their wits end” requesting guidance on how to get their EMS supplier to “start doing the job their getting paid for”, i.e. managing their supply chain and to quit bothering them.

Inevitably these telephone calls last about 15 minutes and proceed along the following script:

· During the first nine minutes the OEM shares their 3 minute story about their under performing EMS supplier three times over.

· During the tenth minute I tell them they need to call their EMS supplier and thank them for keeping them in-the-loop.

· During the eleventh minute the OEM (usually loudly) asks me if I listened to what they’d said during the first nine minutes of the call.

· During the twelfth to fourteenth minute I explain that they’re navigating through dangerous waters with a radar clouded by Chaff and that they need to consider and react based on the human nature aspects of the situation, which includes:

1. Positively reinforcing their EMS supplier’s behavior (i.e. calling for help), as to do otherwise might mean that the next time there’s a problem they (the OEM) will not hear about it until it’s too late.

2. Negatively reinforcing their component supplier’s behavior (i.e. withholding resolution until the OEM calls) by informing them that in the future they (the OEM) would appreciate it if they started working more closely with their EMS supplier.

· During the fifteenth minute the OEM usually grumbles something along the lines of, “OK, I see your point but I’m not very happy about any of this. We’ll probably end-up doing what you’re suggesting but I’m not happy about any of this – not very happy at all!” And then abruptly hangs-up without offering much in the way of a valediction.

Such is the life of a consultant.

Fundamental Tenets of Business

Lastly are the Fundamental Tenets of Business. While there are many Business Tenets, perhaps the most important relative to outsourcing is:

Margin is the difference between the cost of revenue and selling price and is applied to all underlying costs equally.

As a tenet (or something accepted as an important truth[3]) the above statement tells us – unequivocally – that there are more misconceptions about pricing and the true cost of outsourcing than there are accurate conceptions!

While it would take tens-of-thousands of words to construct a comprehensive list of all the misconceptions, false impressions, and erroneous beliefs floating around clouding the True Cost of Outsourcing radar, the author’s top-six “myth busting facts” are listed below:

1. Material mark-up is a contrivance and isn’t a real accounting process.
2. All materials are margined at the same percentage no matter how you try to break it out.
3. It is virtually impossible for OEMs to accurately estimate the non-material elements of COGS (i.e. labor and overhead) as their cost accounting methodologies vary too widely from those used in the service industry.
4. Profit is the difference between actual and standards and therefore does not exist until an operational transaction takes place, therefore the term “profit” can never be applied in the quoting process.
5. Material, in spite of its placement on the Balance Sheet as an asset, is almost always a liability operationally and therefore needs to be treated as such in the quoting process.
6. Using geographically remote or complex outsourcing solutions always costs more to manage than local, less complex alternatives.

All of which has resulted in an industry (the EMS industry) that in 2005, according to Technology Forecasters[4], on average failed to make a net profit or yield a positive return on invested capital.

Why is this important? I guess it would depend on for whom you are working:

If you work for a non-EMS supply chain provider (e.g. component supplier, 3PL, software company, capital equipment manufacturer, etc.) then:

· Both your OEM and EMS customers are at risk (i.e. your EMS customer because they may not be profitable and your OEM customer because they may fail as a result of their EMS service provider.)

1. If you work for an EMS supplier or a provider of EMS like services then:

· Your job may be at risk as your employer might be slowly going out of business.

1. If you work for an OEM or user of EMS services then:

· Your job may be at risk as someone is going to get blamed for the failure of your outsourced supply solution that is slowly going out of business.

Not a pretty picture and one that’s hard enough to paint in person over the course of an entire day at a Global Pricing Workshop much less than within the constraints of a commentary of this type – nonetheless the fundamental tenet of the example is self evident.

Having great leverage in a business relationship, as OEMs have enjoyed for many years over their EMS service providers, can be a dangerous thing as pressing an advantage beyond what works to your advantage is an easy thing to do but can have far reaching negative consequences.

Fortunately, OEMs are beginning to realize as they look outside the edges of their own enterprise that:

· Critical industries (like EMS) are in disarray and need to be salvaged or they will have little choice but to abandon their outsourcing model and start re-building their own internal factories,

· Supply sectors they’ve helped to create (like ODMs) are now competing directly against them and that in many low-cost regions these new competitors have already fully secured the market-share the OEMs intended to serve by means of their ODM outsourcing initiatives,

Obviously, when navigating in the outsourcing sea it’s good to do so with a clear radar screen, which shouldn’t be a problem as long as there isn’t any Chaff floating around from misunderstandings related to Common Sense, Human Nature, and the Fundamental Tenets of Business!

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[1] http://en.wikipedia.org/wiki/Chaff_(radar_countermeasure)[2] GPW V10.R2/GO Tool V2.R6bii data base, as of May 06, listing 29 of 88 cases out of 384 total[3] Definition from Encarta Dictionary: English (North American) Online

[4] TFI Q2 2006 QF Report, Annual Productivity Benchmark of EMS & ODM Companies by Size

Tags: EMS insider insights, Leading indicators, OEM strategies by Charlie
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